Macroeconomics

What should we do about the Indian economy? A wide-angled perspective - II

  • Blog Post Date 28 September, 2019
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Ashok Kotwal

Editor-in-Chief, Ideas for India; University of British Columbia

ashok.kotwal@ubc.ca

In the previous part of this series, Ashok Kotwal and Pronab Sen described the generic process of development in a dual economy. In this part, they present the strategies employed by successful Asian countries that led to a total structural transformation of their economies. They further explain the unique problems that make India’s progress on this front difficult.

This piece was written for The India Forum by I4I Editors Ashok Kotwal and Pronab Sen: https://www.theindiaforum.in/article/what-should-we-do-about-indian-economy

A successful developmental strategy

Except for the city-states like Hong Kong and Singapore, all the successful Asian countries were primarily agrarian before they industrialised. What they accomplished within 20 years was a total transformation of their economies.

Initially, the policymakers concentrated on increasing productivity in agriculture. This directly increased the incomes of the rural population, and, in addition, allowed a higher level of agricultural exports that would, in turn, enable imports of machinery and technology.

Late-developing countries have the advantage that they can rapidly improve their productivity by transferring technology from developed countries rather than having to invent it themselves. Some of the technology transfer is done through foreign investment and the rest through direct purchase or copying. However, in order to absorb the transferred technology they need a well-trained labour force and supporting infrastructure. Moreover, in order to sustain a high rate of capital formation, they needed to have a high rate of domestic savings. All the Asian success stories paid due diligence to these essential aspects of development.

When a country industrialises in a transformative way, it needs to undertake some major structural reforms. In order to facilitate a movement of land and labour to their more productive use, laws pertaining to land and labour may have to be reformed. In order to facilitate savings by households, the financial system needs to be modernised. The financial system should be easily accessible for people no matter where they live, and should also be able to inspire trust. Foreign investors should be assured of legal protection of their intellectual property rights. The success of these Asian countries was based on these basic preliminaries.

Another crucial aspect of their development strategy was to start by focusing on producing labour-intensive goods (textiles, footwear, toys, etc.) for the markets in developed countries. They could thus take advantage of their cheap labour and then produce these goods in quantities far in excess of what they could have sold domestically. Thus, domestic demand was never a constraint for them in expanding their industries producing goods in which they had a comparative advantage.

There is a certain logic behind this export-led strategy for fast growth. First, when firms can see that there is a potential market for their products they are inclined to make investments. Second, to be able to accumulate capital, a country needs to have a high savings rate; but high savings imply low domestic consumption and hence low domestic demand. However, when a country produces for foreign markets, the trade-off between savings and consumption becomes irrelevant. It can afford to have a high savings rate domestically. With access to export markets, it can have both high domestic savings and high demand coming from consumption abroad. In addition, there is a much greater choice in what to produce as the world demand is bound to be more diverse than domestic demand.

The manufacturing sector, especially labour-intensive manufacturing, does not require years of university education to acquire the requisite skills. A high-school graduate or less with some on the job training is often adequate for most of the jobs in manufacturing. Surplus labour from the informal sector, including agriculture, can move into labour-intensive manufacturing with minimum additional training, as long as they have basic skills like literacy and numeracy. This is what happened in Taiwan, South Korea, Thailand, Indonesia and China. Lately, even Vietnam and Bangladesh have followed course.

Most importantly, as their industrial sector expanded, they absorbed more and more labour from agriculture – a sector with markedly lower productivity. Poverty declined as labour moved to a more productive sector, and the productivity of the remaining agricultural labour also increased. The growth was fast and also inclusive.

It is important to mention that their respective governments actively aided this effort to develop a manufacturing sector in selected areas with an eye to export markets. This was done through an industrial policy that included low interest loans, land grants, tax holidays and requisite infrastructure like power, container ports and other transportation networks. Albeit, it is easier to do it in countries where the democratic norms are rather flexible.

Why has India failed to follow the East Asian script?

Unlike the East and Southeast Asian governments, the Indian government did not direct the course of the post-1991 growth. Liberalisation certainly helped unleash market forces but the course of development was determined more or less through serendipity.

When the Licence Raj ended in 1991, a few significant aspects of the reforms determined the subsequent course of the Indian growth story. In 1992, the government monopoly on the communication sector officially ended. The years between 1994 and 1999 saw a great deal of churning in this sector. Gradually, cell phones became pervasive. This was an opportune time for communication technology to take off in India. Due to excessive emphasis on public sector investments since 1960s in high-end technical and managerial institutions like the IITs (Indian Institutes of Technology) and IIMs (Indian Institutes of Management), there was a surplus of highly trained manpower available.

At the same time, there was a sudden surge of demand all over the world for IT professionals as the Internet was appearing on the world stage. Indian engineers who were over-skilled for the Indian market had been migrating to the US since 1960s where they had managed to establish quite a reputation. All this turned out to be fortuitous for Indian firms like TCS, WIPRO, and Infosys to emerge on the world stage. Communications and business services grew to be India’s fastest growing sectors from 1993 to 2004 at 20.7% and 24.3% per annum, respectively. Software exports grew at the astronomical rate of 34% per annum over that period (Gangopadhyay et al. 2008).

India’s fast growth episode was propelled by exports of IT services. It was indeed an export-led growth. However, unlike China’s or South Korea’s growth through manufactured exports that absorbed low skilled labour in vast numbers, India’s growth episode was led by a high skilled service sector that failed to adequately absorb unskilled labour from agriculture.

In the early 1990s, India could have also developed its manufacturing exports like China and South Korea did. But there were several major obstacles: restrictive labour laws that created incentives for keeping the scale small; an outdated land acquisition law that made the process of acquiring land extremely messy; weak infrastructure limiting access to power, ports, and roads; and, most importantly, a badly educated labour force. Successive governments have found it challenging to address – let alone overcome – these obstacles.

India has some unique problems that make any progress on this front difficult. First, any laws pertaining to agriculture and land are in the State List of the Constitution. This means that each state makes its own laws. The Centre can only over-ride them if and only if they are repugnant to a law passed by Parliament. Land is also designated by whether it is agricultural land or not. In order to locate a large industrial project on any land designated as agricultural land, the state government needs to buy it from the farmers and sell it to the industrial house, or change the land-use classification of the concerned area. In most states, this is a source of massive corruption, and creates incentives for state politicians to block any attempt by the Centre to change these laws.

Labour laws are in the Concurrent List of the Constitution. This means that the residual powers remain with the Centre, and the Central Government has greater degrees of freedom to change the laws. Yet, successive governments have found it politically difficult to do so. Rajasthan made some changes under the Bharatiya Janata Party (BJP) state government, but these changes were marginal.

The existing laws are set up so as to put more restrictions on larger employers, especially with regard to adjusting the work force in response to changes in demand. This discourages attaining scales that would allow Indian manufacturers to compete internationally. These laws can be endured in situations where demand does not move cyclically, which was the case in India for many years in the past. However, international markets are notoriously cyclical, and firms need to adjust their output with a fair degree of flexibility.

More importantly, since the mid-1990s, the Indian economy too has been displaying distinct business cycle behaviour, which makes the impact of these laws even more damaging. In fact, this could be an important factor driving the process of automation and robotics in Indian industry.

After China entered the World Trade Organization (WTO) in 1999, it went on to occupy most of the unfilled space in the developed countries’ markets for manufactured goods. ‘Made in China’ became a universal brand. It became much more difficult for countries like India to compete with China after that. In addition, the climate for international trade has recently changed. Developed countries have witnessed a denuding of their manufacturing sectors, and the widespread resentment due to it has led to the election of right-wing nationalists like Donald Trump. Countries such as the US are not so receptive any more to importing cheaper goods from low wage countries.

Moreover, Indian workers now have to compete not just with Chinese and Vietnamese workers but also with robots and artificial intelligence. Even in India, firms have strong incentives to make production more capital-intensive. This is not just because of labour laws but also because long-term interest rates are not that much higher than short-term interest rates. The long and short of this is that inclusive growth is a far more difficult prospect for India in 2020 than for China in 2000.

Yet, we must ask how other democratic nations like Thailand, Malaysia, and Indonesia have managed to solve these problems – especially the problem of skilling the labour force. Even Bangladesh managed to develop a strong textile sector that could compete in international markets. When primary and secondary education itself fails to impart basic literacy and numeracy, any subsequent skilling programme is bound to fail. Why has public education been such a challenge for India?

The genesis of India’s present problems of a lack of job creation and rural distress lies in these factors.

It is important to note that the Asian success stories including that of China were based on an extremely high rate of investment. You need investment to create jobs and wages by bringing in new technology as well as by adding more capital (machines). India’s investment rate has not been bad at all, compared to the other Asian countries, except China. But it has faltered of late, particularly post the Global Financial Crisis (GFC) of 2008.

Why have the growth of domestic investment and consequently the rate of gross capital formation slowed down during this decade?

The analysis and arguments in this series have benefited from discussions in recent times that both authors have had with a large number of individuals, far more than can be named here. Our thanks to all of them.

Ashok Kotwal would like to thank Parikshit Ghosh, Ashwini Kulkarni, Milind Murugkar, and Bharat Ramaswami for many useful conversations.

The third part of this series will be posted on Sunday, 29 September 2019

Further Reading

  • Gangopadhyay, S, MG Singh and N Singh (2008), Waiting to Connect: Indian IT Revolution Bypasses the Domestic Industry, Lexis – Nexis Butterworth, New Delhi.
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